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By R. Daniel O’Connor, Sunil Shenoi, Greg Demers, and Dante Roldan

Dan O’Connor is a partner in Ropes & Gray LLP business and securities litigation group
whose practice focuses on securities enforcement matters, internal investigations,
related trial work and compliance consulting. Sunil Shenoi, Greg Demers, and Dante
Roldan are litigation associates practicing in the firm’s business and securities
litigation group.

During the final months of Chair Mary Jo White’s leadership of the Securities and
Exchange Commission (the “Commission” or “SEC”) (October 2016 through January 2017),
the SEC settled a series of enforcement cases involving mostly minor accounting and
disclosure issues. These settlements, described more fully below, illustrate an SEC
enforcement trend that has been developing over the last several years that has led
to an uptick in actions involving negligent or non-scienter accounting, internal controls,
and/or books and records violations—in addition to the more common accounting fraud
charges. As described, below the negligence cases often involve the SEC evaluating
subjective decision processes employed by a company in complex matters of accounting,
where the staff seems willing to second guess management and substitute its judgment,
likely often with hindsight. These cases serve as a strong reminder that the SEC’s
enforcement division remains focused on pursuing public company cases. And it is also
possible that these easier to prove, negligence cases will find more favor with the
incoming enforcement staff. Whether this trend will continue during the Trump administration
is unclear, but companies should nevertheless exercise great care and regularly evaluate
their accounting and disclosure controls and realize that these cases will at least
be used by auditors as they follow through with their audit processes.

I. Financial Reporting Processes.

On Nov. 7, 2016,
PowerSecure International (“PowerSecure”), an energy management firm, agreed to settle the SEC’s claims related to PowerSecure’s
process for determining and reporting operating segment financial performance. Pursuant
to ASC 280, a company is required to determine its operating segments “based on the
way management organizes its business components to make operating decisions and assess
performance.” The SEC alleged that instead of disclosing financial information in
the management discussion and analysis sections of its periodic filings about seven
smaller operating segments, PowerSecure improperly aggregated and disclosed the financial
results of these seven smaller operating segments as one reporting segment for 2012
to Q1 2014, as three reporting segments for Q2 2014 to Q4 2014, and as four reporting
segments for 2015. In its Form 10-K for year- end 2015, PowerSecure disclosed that
its segment reporting was incorrect from 2012 through 2014 and revised that prior
year information accordingly, consistent with its 2015 reportable segments.

PowerSecure’s prior practice was allegedly inconsistent with “how the company was
structured” and how the CEO regularly reviewed operating results and assessed performance,
which the SEC alleged occurred on “a more disaggregated level than the consolidated
[segment].” The SEC further alleged that “PowerSecure did not have a segment reporting
policy, and there was limited documentation of its segment reporting requirements.”
The SEC claimed that PowerSecure’s segment disclosure was not in accordance with generally
accepted accounting principles (GAAP), that PowerSecure tested goodwill impairment
at a higher level in the organization than appropriate, and that PowerSecure lacked
sufficient internal accounting controls. As a result of these deficiencies, the SEC
charged PowerSecure with non-scienter-based violations of Section 13(a) of the Exchange
Act and Rules 13a-1, 13a-13, and 12b-20 thereunder and Sections 13(b)(2)(A) and 13(b)(2)(B)
of the Exchange Act. Without admitting or denying the allegations, PowerSecure settled
the SEC’s claims by agreeing to pay a $470,000 civil monetary penalty.

On Jan. 18, 2017,
General Motors (“GM”) agreed to settle the SEC’s claims related to GM’s process for identifying and evaluating
loss contingencies. Starting in 2014, GM recalled approximately 30 million cars worldwide
related to a defective ignition switch that could cause the engine to shut off during
driving and prevent the vehicle’s airbags from deploying. The SEC alleged that certain
GM personnel understood that the ignition switch represented a potential safety issue
in the spring of 2012, but the GM’s Warranty Group, which was responsible for the
accounting treatment of possible losses related to potential recalls, didn’t learn
about the likely recall until November 2013. Once the Warranty Group finally learned
of the likely recall, it determined to accrue approximately $41 million for the estimated
costs of the recall, but the SEC alleged that GM’s consideration of a loss contingency
related to the ignition switch was too late. Specifically, the SEC alleged that prior
to November 2013, GM should have considered whether a loss was “reasonably possible”
and whether disclosure was required under ASC 450, rather than waiting until November
2013—when a recall was probable and the costs of the recall were estimable. The SEC
alleged that this episode illustrated GM’s lack of adequate internal accounting controls,
and GM settled the SEC’s claims by agreeing to pay a $1 million civil penalty. Notably,
GM announced the SEC investigation in April 2014, but it then took nearly three years
to reach a settlement on these facts, during which the company likely endured substantial
legal fees and costs, as well as the overhang caused by the existence of an SEC investigation.

Both settlements here are noteworthy due to the lack of allegations of intentional
misconduct. The SEC didn’t allege why GM’s Warranty Group wasn’t told about a potential
recall, nor did the SEC ascribe ill-intent to PowerSecure’s determination that it
had at most four reporting segments, rather than seven. Moreover, neither of these
settlements involved allegations that the improper conduct changed the amount of any
reported financials. The SEC only alleged that GM should have
considered a disclosure earlier, not that its subsequent $41 million loss contingency should
have been
recorded earlier. Similarly, the SEC only alleged that PowerSecure tested its goodwill impairment
at a higher level than was appropriate, not that the magnitude of any goodwill impairment
was improper.

II. Subsequent Accounting Adjustments.

On Oct. 20, 2016,
FMC Technologies (“FMC”) agreed to settle the SEC’s claims relating to improper accounting adjustments and
internal controls failures. In January 2013, a business unit-level accounting team
decided to change the method for accruing paid time off (PTO) liability from annually
to ratably each month, contravening GAAP and FMC’s accounting policies that required
annual accruals because employees accrued PTO annually. The accounting team then reversed
the 2013 annual PTO accrual by almost $800,000, which led to an overstatement of the
applicable segment’s profits and enabled the segment to meet its internal target.
In Q2 2013, the accounting team decided to eliminate the PTO accrual altogether, which
was not in compliance with GAAP. The SEC alleged that FMC further violated GAAP by
failing to conduct measurements of currency fluctuations that were required by ASC
830 in connection with an inter-company loan between two of FMC’s subsidiaries. Although
the failure to remeasure didn’t require FMC to amend prior filings, it led to an $8.1
million out-of-period adjustment in September 2014. FMC settled the SEC’s claims of
inaccurate books and records and inadequate internal controls by agreeing to pay a
$2.5 million penalty.

On Jan. 19, 2017,
HomeStreet Inc. agreed to settle the SEC’s claims that it conducted improper hedge accounting. The
SEC alleged that from 2006 to 2008, HomeStreet originated approximately 20 fixed-rate
commercial loans and then made interest rate swaps to hedge the exposure. Pursuant
to ASC 815, HomeStreet “designate[d] the loans and the swaps in fair value hedging
relationships, which can reduce income statement volatility.” However, ASC 815 also
requires that companies “periodically assess the hedging relationship and must discontinue
the use of hedge accounting if the effectiveness ratio falls outside a certain range.”
The SEC alleged that HomeStreet’s Treasurer instructed and oversaw a process in which
Treasury employees from 2011 to 2014 provided adjusted inputs and test results regarding
HomeStreet’s hedge effectiveness testing to HomeStreet’s accounting department, and
as a result, HomeStreet had inaccurate accounting entries. This process allegedly
violated both GAAP and the company’s internal accounting policies, and the SEC alleged
that HomeStreet didn’t have proper books and records and internal accounting controls.
HomeStreet settled the SEC’s claims by agreeing to pay a penalty of $500,000. In addition,
HomeStreet’s Treasurer agreed to settle the SEC’s claims that he caused HomeStreet’s
violations.

These two settlements—neither of which required a restatement of financials—involved
unsupported accounting adjustments to initially correct accounting treatment, but
the fines imposed on each company varied significantly. This variance might be tied
to the potential impact of the accounting errors to the financial statements, as FMC
was fined $2.5 million for two accounting errors that led to an overstatement of profits
by $800,000 and an additional $8.1 million unrealized foreign currency loss, whereas
HomeStreet made 64 improper adjustments to its loan fair value calculations that management
later determined did not materially impact any reporting period. These cases also
illustrate that companies must exercise caution in changing accounting methodologies,
even years after an event was initially recorded.

III. Non-GAAP Accounting Measures.

The SEC has also begun cracking down on the improper use of non-GAAP accounting measures
that could be misleading to investors. On Sept. 8, 2016, the Commission charged the
former Chief Financial Officer and Chief Accounting Officer of
American Reality Capital Properties (“ARCP”), a large publicly traded real estate investment trust now known as VEREIT, Inc.,
with overstating ARCP’s financial performance by manipulating the calculation of ARCP’s
adjusted funds from operations (“AFFO”), a non-GAAP metric that is viewed by analysts
and investors as a key indicator of a REIT’s performance. After warnings from ARCP
accounting personnel that the company had used an incorrect method to calculate AFFO
in its first quarter 2014 10-Q filing, ARCP’s CFO and CAO allegedly falsified the
company’s presentation to investors shortly before filing its second quarter results
in an effort to conceal the first quarter overstatement. The SEC charged the two former
executives with fraud under Section 10(b) and Rule 10b-5, as well as aiding and abetting
violations of Exchange Act Section 13(a) and Rules 12b-20, 13a-11, and 13a-13.

On Jan. 18, 2017, New York-based marketing company
MDC Partners agreed to settle claims by the SEC that it failed to disclose certain perks offered
to its former CEO and also used misleading non-GAAP measures. The latter involved
a metric called “organic revenue growth,” which excluded acquisitions and foreign
exchange impacts from the company’s revenue growth calculation. The SEC alleged that
during the second quarter of 2012 through year end 2013, MDC included a third, undisclosed
reconciling item in its calculation of organic revenue growth, which overstated that
metric. MDC also allegedly violated the “prominence” requirement, which requires that
GAAP measures be given equal or greater prominence than non-GAAP measures in a company’s
financials. MDC agreed to settle the charges for a $1.5 million civil penalty.

The use of non-GAAP accounting has become increasingly common in recent years. The
ARCP and MDC cases are an indication that the SEC’s enforcement staff is viewing these
disclosures with greater scrutiny. The ARCP case alone might be dismissed as an outlier,
given that it involved a rather extreme set of facts involving the alleged manipulation
of a company’s financials by two senior executives the day before an investor presentation;
however, the SEC’s action against MDC suggest that non-GAAP accounting measures confirm
that ARCP was not a one-off enforcement action. While the undisclosed perks to MDC’s
CEO made the company a particularly attractive target, much of the SEC’s cease-and-desist
order focused on MDC’s use of non-GAAP accounting metrics in its financial disclosures.
The fact that the SEC based its charges in part on non-compliance with the prominence
requirement is particularly noteworthy, as that requirement affords the SEC a considerable
amount of prosecutorial discretion (in determining the relative prominence of GAAP
and non-GAAP metrics) and can be problematic for companies like real estate investment
trusts that tend to rely heavily on non-GAAP metrics to measure financial performance.

IV. Revenue Recognition.

On Oct. 17, 2016,
Lime Energy Co. (“Lime”) agreed to settle the SEC’s claims that it improperly recognized millions of dollars
in revenue from 2010 to 2012 using increasingly aggressive (and improper) accounting
tactics. The SEC alleged that in 2010, Lime’s utilities division recognized revenue
using the “percentage of completion” method, such that as costs incurred on a project
increased, so did revenue. But the utilities division’s internal accounting controls
allegedly allowed journal entries to be entered for project costs based on a personal
assurance that documentation for the costs existed, rather than actually requiring
documentary support. Thus, in 2010, Lime allegedly booked revenue for certain projects
where it had no documentation of its costs, even though Lime had not received appropriate
documentation of its own expenses to justify that it had earned revenue. From there,
Lime allegedly booked millions in revenue after the close of the year end for 2011.
And in 2011 and 2012, Lime’s management allegedly directed the recognition of revenue
for projects that didn’t exist. Lime eventually determined that it had overstated
its revenue from 2010 to 2011 by approximately $40 million, and Lime restated its
financials for 2008—2011 and Q1 2012. The SEC alleged that Lime violated the anti-fraud,
books and records, and internal controls provisions of federal securities laws, and
Lime settled the charges by agreeing to pay a $1 million civil penalty. Four members
of Lime’s management also reached settlements with the SEC relating to their roles
in the improper revenue recognition scheme.

On Jan. 11, 2017,
L3 Technologies Inc. (“L3”) agreed to settle the SEC’s claims that it improperly recognized revenue relating
to a government contract with the U.S. Army. From 2010 to 2013, L3 performed $50 million
in work for the U.S. Army, but by the end of 2013, the U.S. Army had not yet validated
that the work had been completed and L3 had not yet billed the U.S. Army for the work.
Nevertheless, in December 2013, an L3 finance official directed L3 to generate 69
invoices for its work, without delivering the invoices to the U.S. Army. One of the
requirements for revenue recognition under ASC 605 is that collectability must be
reasonably assured, but since the U.S. Army had not reviewed or agreed to pay the
invoices, any recognition of revenue relating to these invoices would have been inappropriate.
Yet L3 recognized $17.9 million in revenue, which allowed several L3 employees to
“barely satisfy the target required in order to qualify for management incentive bonuses.”
An internal investigation conducted by outside advisers six months later detected
both this improperly recognized revenue and other accounting errors made from 2011
to 2014. The aggregate result was that L3 had overstated its pre-tax income by $169
million, and was forced to restate its financials for 2011 through 2014. The SEC alleged
that L3 didn’t have proper books and records and internal accounting controls, and
L3 agreed to pay a $1.6 million penalty to settle the charges.

Notably, both companies agreed to settle their investigations for civil penalties
under $2 million, even though the magnitude of each company’s accounting errors was
more than ten times the amount of the penalty. Both companies’ accounting errors also
involved direction from senior management, but only Lime involved allegations of fraud.
One explanation for this discrepancy might be that Lime involved several instances
of improper conduct over three years by four members of a business unit’s senior management,
whereas L3 involved a single improper act one member of a business unit’s senior management.
In addition, Lime sold $2.55 million in common stock to one of its board members based
on Lime’s allegedly false financial statements, whereas L3 did not involve any sales
of securities.

V. Implications.

These cases demonstrate that the SEC is willing to bring enforcement actions where
the ultimate penalty is fairly small and the conduct at issue only involves negligence,
often related to events that are immaterial to a company’s reported financials. This
trend is consistent with the range of initiatives
announced by former SEC Director of Enforcement Robert Khuzami in 2010, “designed to increase [the SEC’s] ability to identify hidden or emerging
threats to the markets, and act quickly to halt misconduct and minimize investor harm.”
Since that date, the SEC has aggressively pursued matters that were historically considered
to be lesser infractions, culminating in this string of accounting actions that were
settled shortly before the change in administrations.

An important component of this trend is that the improper conduct need not be intentional.
For example, neither of the financial reporting cases (PowerSecure and GM) or the
accounting adjustment cases (FMC and Home Street) involved allegations that management
was intentionally manipulating the company’s financials. Nonetheless, the SEC pursued
actions against all of these companies. While the civil penalties were comparatively
small, a protracted enforcement action will often result in significant legal and
expert fees. In addition, reputational harm and the uncertainty that can exist in
the market during the pendency of an SEC inquiry can far outweigh the monetary penalties
that the SEC might pursue.

As a result, companies should periodically reassess their financial reporting processes
to minimize risk and the potential for future enforcement actions. Ensuring that all
key stakeholders within the company have input in and ownership of the company’s reporting
process can often ensure that changes or shifts within the business are caught early
and their disclosure implications fairly considered. It is also important to maintain
transparency with external auditors regarding the effectiveness of internal controls
and to regularly identify areas that might need improvement or reinforcement. Detailed
record-keeping of these communications involving thoughtful discussions by qualified
personnel will often influence the course of an investigation.

It is difficult to anticipate how this trend will evolve—or whether it will continue
at all—under the Trump administration. However, enforcement trends generally do not
change overnight, and it is best practice for companies to regularly review their
internal controls and reporting processes to put themselves in a strong position to
deflect any form of heightened scrutiny that may come down the line.

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